Article

Factual Summary:Seller, an Indian company forming part of the Hamco group of companies controlled by B.M. Patel, entered into a contract for the sale of tin ingots to Buyer, an English company trading in metals controlled by Patel's son, Madhav Patel. By the terms of the contract, Buyer was to provide a US$10 million pre-export advance to Seller from funds loaned by Standard Bank. The advance was paid through Seller's bank. As collateral for the advance, Seller obtained a US$10 million demand performance guarantee issued by its bank (Guarantor) in favor of Buyer, which subsequently assigned it to Standard Bank as security. The pre-export advance was to be repaid in equal installments based on each shipment, and Guarantor's liability under the performance guarantee would be reduced accordingly. Instead of releasing the full amount of the pre-export advance to Seller as the parties had contemplated, Guarantor retained the funds as cash collateral for the performance guarantee.

As issued, the independent guarantee contained the following clause:

"Our liability under this guarantee shall not be reduced, discharged or otherwise adversely affected by any invalidity, illegality, unenforceability, irregularity, frustration or discharge by operation of law or any actual or purported illegality of [the purchase contract], or [of] any security held from [Seller/Principal] or any other person in connection with, the purchase contract."

After 20 months, Seller and Buyer entered into a new supply contract that was to supersede the first. At that time, Guarantor returned to Standard Bank that portion of the pre-export advance that had not yet been released to Seller and repaid. By the terms of the second contract, Buyer provided a US$20 million pre-export advance to Seller. Buyer financed the advance through a syndicate of lenders led by Standard Bank based on the strength of a pending off-take (re-sale) agreement with a third party purchaser to whom Buyer made spot sales when Buyer received shipments under the first supply contract. The advance was again routed through Guarantor which provided a new US$ 10 million demand performance guarantee in the form of an amendment to the original, which had been assigned to Standard Bank.

Unbeknownst to the financing parties, the first supply contract was a sham, the fruits of which were to have been the pre-export advance funds. Since the funds were retained by Guarantor, the plan was defeated. Evidence showed that Seller, Buyer and other related companies "were engaged in a widespread and systematic fraud by which vast sums of money were obtained from a number of banks throughout India and the Gulf" during the entire period of their contractual relationship, including insurance frauds, shipping frauds and letter of credit frauds. It appeared that the third party purchaser with whom Buyer had the off-take agreement that the lending syndicate had relied on when extending financing, was already engaged in a long-term supply contract with Seller for the purchase of tin. The third party regarded Buyer as an agent of Seller, and was content to accept shipments and shipping documents from either party. The third party supply contract was ultimately canceled just prior to the institution of the off-take agreement. It did not appear that Seller had had the potential to produce enough tin to satisfy its supply contracts with both the third party supplier and Buyer. Instead, goods that were initially committed to the third party were passed through Buyer, which added its own invoice to the shipping documents and forwarded the documents on to the third party supplier.

The discovery of this fraud was noted by the court:

"The fraud was organised in a complex and highly sophisticated manner, involving the production by Solo UAE and other companies working in conjunction with it of substantial numbers of false documents, such as bills of lading, freight invoices, insurance certificates and correspondence purporting to emanate from a variety of commercial concerns. The scheme took a variety of forms, but one of the principal methods adopted was the so-called 'import' fraud. Hamco or one of its associated companies would purport to enter into a contract with a foreign company controlled by Madhav Patel or one of his associates for the purchase of goods for import into India on cif terms. A letter of credit would be opened under a facility negotiated with a commercial bank, but the contract was sham and no goods were shipped. In order to obtain the funds represented by the letter of credit false documents were created by Solo UAE which were tendered to the bank to obtain payment. Funds representing the face value of the letter of credit thus passed into the hands of Hamco's accomplices. In some cases funds were obtained by discounting bills of exchange. In order to conceal the fact that no goods existed further documents were created to give the appearance that the goods had been lost in transit and that a claim had been made against the cargo insurers. Funds derived from previous fraudulent transactions were remitted to Hamco under the guise of insurance proceeds. Part of the funds was used by Hamco to discharge its liability to the bank and the remainder for its own purposes. Since this scheme required a constant recycling of funds, ever-increasing amounts of money were required to keep the process going. Another aspect of the fraud, though one which is of less immediate significance to the present action involved the creation of false export contracts under which goods were sold by Solo UAE and other members of the group to companies controlled by Madhav Patel or his associates. Again, false documents were created to give an appearance of genuine export contracts being performed in the usual way. All this activity called for a sophisticated means of creating false documents and an effective system for controlling the flow of funds in order to keep the operation running. That was provided by Solo UAE from its office in Sharjah. Eventually the Indian banking authorities became concerned at the extent of Hamco's apparent failure to file documents evidencing the import of goods as required under Indian legislation. They began to make enquiries and as a result of their investigations the fraud eventually came to light."

After several months of operation, the supply contract collapsed. When Standard Bank made a demand on Guarantor's performance guarantee, Guarantor refused payment, claiming that the underlying contract was a "sham" and that the guarantee had been procured by fraud. Standard Bank subsequently sued for wrongful dishonor. Judgment for Standard Bank against Guarantor.

Legal Analysis:

1. Fraud: Guarantor argued that the first contract was a sham designed to net Seller the US$ 10 million pre-export advance. When Guarantor retained the funds as collateral for the performance guarantee, Buyer and Seller were forced to obtain a greater preexport advance that was secured by a lesser performance guarantee. It contended:

"[T]he guarantee was void by reason of the failure of an implied condition precedent that the contract in support of which it was issued was a genuine and valid contract which the parties intended to perform in accordance with its terms; alternatively, that it had been induced to enter into the guarantee by an implied representation to that effect on the part of [Seller] and that since the contract was in fact a sham it was entitled to avoid the guarantee on the grounds of fraud."

The court, however, was not prepared to rule that the second supply contract was necessarily a sham agreement merely because the first was undoubtedly so. While the court seemed to believe that Buyer obtained financing for the advance to Seller through fraudulent conduct, the off-take agreement with the third party required that legitimate goods be produced and delivered to Buyer for resale to Seller. Despite mounting financial pressures on the parties resulting from their other commercial frauds, the court noted that an active mining and mineral trading business was still in place and that 5,670 metric tons of tin had been exported from India from 1996-1998. Even though the court recognized that a primary motive behind the refinancing of the second Seller supply contract was to "obtain further funds to prop up the group generally rather than to invest in [Seller's] mining project" it did not necessarily follow that the contract was a sham. The court stated that "it is ... important that evidence of dishonesty in other transactions, even on the scale demonstrated in this case, should not lead the court to find dishonesty where none in fact exists."

Since Guarantor's entire defense under the performance guarantee was that the underlying contract was a sham, its defense failed, and the court ordered recovery in favor of Standard Bank for US$10 million.

2. Independence: Guarantor argued that it was an express condition of the guarantee that there be a genuine contract in place between the principal and the beneficiary. The appellate court examined the terms of the guarantee and noted that:

"It is well established that demand guarantees of this kind are normally intended to operate as autonomous contracts in the sense that the guarantor's obligation to pay is not linked to the underlying transaction but depends only on the making of a demand which conforms to the requirements of the guarantee."

It also noted that the guarantee contained a provision that expressly referred to the underlying contract, The court stated that:

"It is apparent from this clause that the parties to the guarantee had turned their minds to the possibility that the purchase contract might fail for various reasons, some within and some outside the control of the parties to it. More importantly, perhaps, they contemplated the possibility that the contract might be altogether invalid or unenforceable as a matter of law. They agreed, however, that in none of these cases should [Guarantor's] liability under the guarantee be affected. This is the strongest of indications not simply that the guarantee was intended to be independent of the purchase contract, but that it was intended to be independent of the legal efficacy of the purchase contract. The fact that [Guarantor's] liability was to remain unaffected by the invalidity, illegality or unenforceability of the purchase contract is a clear indication that the existence of unenforceability of the purchase contract is a clear indication that the existence of enforceable obligations between [Seller] and [Buyer] under the purchase contract was not in any sense a prerequisite of its liability under the guarantee."

Noting that the purpose of the contract was to secure a pre-export advance, the court observed that the performance or validity of the contract itself would not be relevant.

"Its purpose was to ensure that if the purchase contract failed for whatever reason the lender had a means of recovering the loan, albeit only in part. It is difficult to see why the position should be different in a case where the purchase contract, although apparently genuine, is nothing but a sham."

3. Assignment: The court recognized that the beneficiary of the guarantee, the Seller, could not make a demand on the guarantee "not because the claim would fall outside the terms the guarantee, but because it was itself a party to the fraud" but went on to state "[b]ut I see no reason why Standard as an assignee having no knowledge of the fraud could not do so." Although recognizing that the position of an assignee would normally not be better than that of the assignor, the court stated that "but as a matter of principle it is open to the parties to provide by contract for the protection of assignees". After being advised of the assignment, Guarantor amended the guarantee to the effect that:

"Re: All of the assignor's rights, title and interest in a guarantee given by [Guarantor] to [Buyer] ... dated 13th May 1996 and amendment dated 16th December 1997 (the Assigned Property). We hereby acknowledge receipt of a notice of assignment made between [Buyer] (Assignor) and Standard Bank London Limited (Assignee) pursuant to which, inter alia, the Assignor assigned the Assigned Property to the Assignee.

1. We agree to pay all amounts payable by us pursuant to any provision of or otherwise in relation to the Assigned Property to the Assignee and to only accept instructions or demands in respect of the Assigned Property from the Assignee until the Assignee notifies us to the contrary.

2. ...

3. We agree with the Assignee that all sums payable by us to the Assignee pursuant to the Assigned Property shall be paid in full without any set-off or counterclaim and free and clear of all deductions or withholding on account of taxes.

All other terms and conditions contained in our letter of guarantee ... dated 13th May and amendment to the subject guarantee dated 16th December 1997 remain unchanged."

Standard Bank argued that this communication had the effect of establishing a direct obligation running to it and was not merely an acknowledgment of the assignment. The court opined that there was nothing to suggest that there was a novation in favor of the assignee, but stated that: "The real question, however, is whether they intended the assignment to be on terms that [Guarantor] should not be entitled to rely on defences that would have been available against [Buyer]."

Considering the terms of the amendment, the court concluded that "Reading the amendment as a whole I am satisfied that it was the parties' intention that Standard should take the benefit of the assignment free of cross-claims of any kind, including any claim by [Guarantor] to avoid the guarantee on the grounds of fraud on the part of [Seller] and [Buyer]."

4. Disclaimer; Independence; Rights of Assignee:Although the issue was moot, the court felt obligated to offer its opinion as to what the legal effect of the guarantee would have been had the second supply contract between Buyer and Seller been a sham. Guarantor had argued that it was an express or implied condition of the guarantee that that a genuine contract existed between Seller and Buyer.

The court noted that there was an expectation between Principal/Seller and Beneficiary that the guarantee would be assigned to Standard. The court noted a letter that "not only shows that there had been a request that the guarantee should contain a clause permitting its assignment, but that the bank was aware that if the guarantee were capable of being assigned it might become an essential part of the security supporting the financing of the underlying transaction." The court disagreed, noting that the language of the guarantee and the relationship of the parties indicated that the independence of the guarantee should be preserved. Looking to a disclaimer clause in the guarantee, it appeared to the court that the parties had contemplated that the underlying contract might fail for various reasons, including unenforcability as a matter of law, but that the guarantee was intended to be effective independent of the efficacy of the underlying contract.

Furthermore, given that the loan agreement between Standard Bank and Buyer required that the performance guarantee be assignable and Guarantor knew that the guarantee might become an "essential part of the security supporting the financing of the underlying transaction", it was more likely that the guarantee was intended to operate autonomously of the underlying contract. While the court noted that Buyer itself could not have made a valid demand, itself a party to the fraud, Standard Bank would not have been so prevented, since it was an assignee with no knowledge of the fraud.

5. Fraudulent Inducement; Avoidance: Guarantor argued that, if the underlying contract was a sham, it was induced by fraud to issue the guarantee and was entitled as against Buyer and any subsequent assignees to avoid the obligation. While the court noted this was the traditional rule, the parties were free to contract for the protection of assignees and had in fact done so here. When notified of the assignment by Buyer to Standard, Guarantor amended the guarantee to recognize Standard as the assignee. The amendment indicated that the parties intended for Standard to take assignment of the guarantee free of defenses that Guarantor might have asserted against Buyer, and therefore Guarantor would not have been entitled to avoid the guarantee under the guise of fraud.

Comment:

1. Although the court uses the term "assign" to describe the relationship between the guarantor and Standard Bank, it will be apparent when considering the amendment to the guarantee that it was transferred to Standard Bank and that Standard Bank became the guarantor. The paucity of such transactions in guarantee practice and the utter failure of the URDG to even address them does not help.

Nonetheless, by analogy to standby practice, it should be apparent that by virtue of the amendment the transferee had the right to draw on the guarantee and, as such, its rights were independent of any fraud on the part of the original beneficiary of the guarantee. Such an explanation is far more satisfactory that the notion that abstraction of this sort could be created by contract and is far more in alignment with international banking practice.

2. Understood in light of an action by the transferee of an independent guarantee on the guarantee, the decision makes perfect sense and should not have required the almost 40 pages that were devoted to it.

3. Nor would it matter whether or not the second contract also was a "sham". The only question would be whether the transferee ("assignee") of the guarantee acted in good faith.

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